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Follow Up: Your Home a Great Investment or Is It?

I’ve gotten quite a bit of feedback from the entry I posted the other day. For those interested, the Wall Street Journal article from David Crook, Your Home Isn’t the next Egg That You May Think It Is can be viewed at this link.

Have a great weekend.

Your Home a Great Investment or Is It?

What if you bought a home for slightly above $350K and after thirty years sold it for over $1.5 million dollars. Pretty sweet huh?

Not so fast.

Earlier this month, the Wall Street Journal had a great article on the subject. In the article, Why your home isn’t the investment you think it is (subscription required), writer David Crook explained a house isn’t necessarily always a great investment. Initially he started by looking at 30 Years of Home-Price Increases data from the Office of Federal Housing Enterprise Oversight (OFHEO). Home price appreciation varied by location, with the major coastal cities leading in price gains. San Francisco topped the list, appreciating 1,125% or compounding roughly 8.7% annually. But over that time period, the national average was 481% or 5.375% annually.

Now on the surface, the returns may look nice, but most homeowners miss the other half of the picture. Crook explained that in home ownership, the costs incurred to own a home need to be taken into consideration as well. Not only does this include the initial down payment and mortgage principal payments, but they also include mortgage interest, real estate taxes, insurance, ongoing maintenance as well as major repairs and improvements. According to OFHEO, the cost for a person who put 20% down and mortgaged the rest on a $50,000 home back in 1977 would have incurred a conservative estimated cost of $394K over that time-span (not adjusted for inflation). If you bought that house in San Francisco, your $50,000 home would be worth $613,000 now and you would have ended up making money, but certainly much less than the pre-cost 8.7% annualized return. If you fell within the national appreciation average and cost estimates, you would have lost money. Yes, that’s right, lost money.

Curious, I decided to see what returns I would get if I bought a house today in the greater Portland area, using Portland’s historical appreciation rate and the cost assumptions used in the article. I assumed a home purchase price of $362,500, a down payment of 20% with the remainder in a 30 year mortgage at 6.41%. I assumed maintenance and insurance at $350 per month, increasing 3% annually. Since real estate taxes and mortgage interest are tax deductible, I assumed the after-tax cost for someone in the 33% marginal tax bracket. Real estate taxes on a pre-tax basis were assumed to be $5,000, which was $3,350 after the tax deduction was implied, this was assumed to increase 3% per year.

Over 30 years, how did the homeowner do? That $362,500 house would end up being worth $1,503,081. It sounds nice from a nominal point of view, but over those same thirty years the total cost of the home would have been $972,844. You would have made over half a million dollars and still this appears not too shabby, but remember we are talking over thirty years. This is an extremely long period of time. Before costs, the historical annual appreciation on the house according to OFHEO was only 4.855% (since 1984, the first year OFHEO kept track of the Portland area). That’s not a lot to begin with. What is the rate of return after costs? You are talking a time weighted return just north of 2%. Better than stuffing cash in your mattress, but not that far behind it either. And bear in mind that this analysis did not take into consideration commissions and costs for buying and selling the property, possible capital gains implications on the sale or major repairs or renovations; OFHEO assumes that the typical single family home will have $300K in renovations in repairs over the next 30 years. Take these costs into consideration and you can certainly be far worse off, possibly losing money in the long-term.

The point is that a home should be viewed as a use asset, something to hold and enjoy from a qualitative perspective. Sorry it is not an investment. For the prospective buyer, don’t fall in the trap of overextending yourself to buy a home due to its “investment value.” For the amateur landlord, you better be pricing your rent appropriately because the annual appreciation only isn’t there to justify the risk you are taking. If someone sells you on the premise that a home is a great investment, just tell them you know better than that.

Retirement Distribution Strategies

In my previous entries on building a better retirement portfolio, I discussed starting with your needs first, then developing growth portfolios with lower volatility by using proper diversification and risk controlled strategies. The next step is to create a distribution strategy. This can save thousands of dollars in taxes and maximize returns, significantly lowering the probability of running out of money during your life. These are the things you should be thinking about:

1.) Set a Periodic Schedule: Once you know your cash flow needs, set a schedule on when to liquidate from your portfolio. Monthly or quarterly is ideal. I recommend keeping one to two years of your needs in a cash equivalent or defensive holding. This serves as a “safety valve” if the market tanks, allowing your portfolio the time to recoup to its original value prior to the drop in the market. Make sure you establish a trigger point when you are going to default to your safety valve. For example, when your portfolio is down over a certain percentage. And better to set this before a down market rather than making ad-hoc decisions in mid-capitulation. This avoids making decisions based on emotion, which never ends up working in your favor.

2.) What to Liquidate First: The key is rebalancing. By now you should know how your portfolio should be broken down between stocks, bonds, cash, other asset classes and underlying sub-categories. Over time, the individual holdings will vary in performance. When you need cash from your portfolio, simply sell assets that will keep the portfolio in line with its original asset allocation. Doing this will always require you to liquidate out-performers as you continue along, selling assets at their high and keeping your portfolio risk in check. In most cases the liquidations will keep things balanced; although every once in a while you may need to rebalance regardless of cash flow needs during a bull or bear market.

3.) Tax Circumstances: Strategy should tie in with your ongoing tax circumstances and account characteristics (see below). For example, the amount of Social Security (SS) that is taxable depends on your income. You may want to liquidate taxable assets trading at a loss or low gain or use tax-free Roth assets to allow you to have more tax free SS income. You may want to use the same strategy if you have a large, one time medical expense; since the deductible amount has to exceed 7.5% of your Adjusted Gross Income (AGI), you want to keep your income as low as possible to maximize the deduction. Or if you have a large balance in a tax-deferred account, you may want to liquidate Traditional IRA funds first or gradually if future required minimum distributions (RMD’s) will put you in a higher income tax bracket later. Tapping into the tax-deferred account may make sense if you are living in a state with no-income taxes now, but plan to move to a state with a high income tax burden. Taxes count so tend to them carefully.

4.) Account Type Investment Strategies and Where to Draw From First: Although everyone has a unique set of tax circumstances (see above), generally you should balance your tax situation with the tax implications of the accounts you hold. Here is how you should be generally thinking about your account strategy:

Regularly Taxable Account: Interest income is taxable at higher ordinary income rates unless tax exempt in some manner. Dividends are taxed at either ordinary or advantageous capital gains rates (until 2011). Short-term capital gains are taxed at ordinary income rates and long-term gains at advantageous rates. Excluding amounts earmarked for the safety valve, the account should be holding primarily stocks or tax-free bonds because they are more tax efficient. In order of timing, generally the brokerage account should be the first account to tap into; assets with higher gains should be considered (unless the higher income has negative ramifications with your personal tax situation) since the current lower long-term capital gains rate is set to expire after 2010.

Tax-Deferred Accounts: Accounts such as Traditional IRA’s or 401(k)’s are taxed as ordinary income when withdrawn. You want to put more of the taxable bonds or other tax-inefficient, mild growth holdings of your asset allocation in this type of account. This is because they will be treated the same from a tax perspective if they were held in a taxable account (just deferred until withdrawn). This will allow you to place higher growth assets in a brokerage account or a Roth where they can compound more with better tax ramifications. Also, placing more defensive assets in a tax-deferred account will tend to compound slower, resulting in lower amounts distributed and taxed at ordinary rates over time. This generally should be tapped into after regularly taxable assets are withdrawn; or together with a taxable account if you have a high balance in tax-deferred accounts and future RMD’s would result in a much higher tax rate in the future.

Tax-Free Accounts: Roth IRA’s/401(k)’s are tax free if the distribution is qualified. Generally you want to put high growth assets into this account. The higher compounding will mean larger amounts that you can draw upon in your later years without any taxes. Since these accounts are not subject to RMD (Roth 401(k)’s are subject to RMD’s, but can be avoided by rolling into a Roth IRA with other stipulations), they have advantageous estate planning characteristics and with higher risk/reward benefits amplifying over a longer time horizon, this should be the last source of retirement funds in most cases.

As you see, there are quite a few moving parts involved, but if you set up an ongoing procedure and structure to tap into the assets, the entire strategy should benefit you over time. You will find that it will enable you to have a much more enjoyable rest of your life and less time worrying about what the future will hold.

Retirement Investing Strategies: Balancing Growth & Volatility

In my last entry, I discussed the issue that most retirees need a portfolio designed with some element of growth while at the same time having mitigated volatility. How do you do this because these two factors work against each other? To get an appropriate balance, this is what you need:

Stock Diversification via Asset Allocation: Diversification in your portfolio if done properly is the glue that provides for growth while mitigating downside volatility. Many people fail at diversification. If you were truly diversified, you wouldn’t have lost nearly half (or more) of your portfolio’s value in the last bear market and you would have recovered several years ago, not just recently. Many people have a problem with asset allocation because they have to accept the fact that at any point in time in their portfolio, there is always going to be something that is doing well and another holding that is doing poorly. That’s what led people to fall into the trap of placing all their money in large growth stocks in the late 90’s and shunning under-performing small and mid-cap value or international stocks; with dire consequences that followed. Small cap value stocks historically have provided the highest returns (with the greatest risk), but you couldn’t tell that to someone in 1999. The focus should be on the forest, not the trees; what matters is overall portfolio performance, not what each individual investment is doing.

Playing Good Defense: Just like in sports, playing a good defense can actually score some points. For example, a good strategy is keeping enough cash reserves on hand. When the stock market tanks, this emergency fund can cover your cash flow needs until the market recovers so you don’t have to sell investments at a cyclical bottom. Bonds also are useful because they are they tend to do well in a deflationary environment when stocks don’t fare nearly as well. Often people view cash and bonds as an “either or” situation, usually chasing the highest yield; but bonds actually appreciate when rates go down where cash equivalents don’t; that’s a big difference. But bonds also aren’t immune to all risk. Another asset class to consider is commodities. Commodities are a terrible asset class if looked at in a vacuum because they lag the stock market for long stretches of time and are extremely volatile. But when added in small doses to a diversified portfolio of stocks and bonds they can actually enhance returns and lower volatility; the best of both worlds. Real estate also adds another layer of sophistication as well. Also, my clients are very familiar with what I call alternative asset classes. These are funds with distinct investment styles that don’t correlate highly with stocks or bonds. Many of these funds that use stock are classified in the long-short category by Morningstar. There are hybrid bond funds as well that fit into the alternative category. In combination, the use of alternatives is designed to create positive returns in all market environments; when added to a portfolio of stocks and bonds, this gives up little in upside potential while substantially mitigating downside risk and should be a consideration for an added layer of protection.

So ask yourself, are you doing the following:

With your stock portfolio, do you have allocations towards domestic, foreign and emerging market stocks (the latter two un-hedged against the dollar)? Is this portfolio broken down between large, mid and small cap stocks? Do you have a good balance between growth and value stocks?

With your bond portfolio, is it aligned with your stock position to match your risk profile? Do you diversify between domestic, foreign and emerging market bonds (the latter two un-hedged against the dollar)? Do you diversify between bonds with short and intermediate term duration? Do you have bonds with varying credit quality? Do you use any hybrid bonds such as TIP’s or floating rate bonds that protect against inflation or higher interest rates?

Have you determined your cash flow need over the next two years beyond what is covered by pensions, Social Security and other non-investment sources? Do you have enough cash on hand to cover the next 1-2 years of cash flow needs? If not, do you have bond or other defensive asset exposure that would cover this need?

Do you use or have considered other asset classes such as real estate, commodities or other alternative strategies to help mitigate risk? Do you look for different asset classes to diversify into?

If you haven’t, then I hope that I gave you something to think about. And this isn’t the cookie cutter breakdown that you will see in those money makeover columns by the financial media. Many of these items are cross related. For example, you can have a part of your stock allocation that could be considered foreign, small cap and value all at the same time. So don’t think of this as a pie chart, think of this diversification as a Rubik’s cube. Want a great example of how asset allocation and diversification works? Check out the article The Math of Recovery by Craig L. Israelsen in the February edition of Financial Planning magazine.

In my last entry, I will be back to discuss the final piece of the puzzle, the actual distribution strategy.

Building a Better Retirement Portfolio

Investment strategy is as much of an art as it is a science. And it can widely vary depending on what you want to accomplish. Developing a portfolio for rest of one’s life has its unique set of circumstances and it is totally different than building a retirement portfolio in during your working years. Before you approach the development of your retirement portfolio, there are three things that you need to understand before even getting into the strategy. And contrary to the commercials you see on television, it has nothing to do with lava lamps, 60’s music and art or film clips of flower children dancing around. It’s not about having “retirement income” (a nice little way to promote the notion of selling you an annuity); it’s about having retirement cash flow. To begin the most important aspect of developing a solid retirement investment strategy is:

Your Needs Come First: Portfolio design should be based on your needs, the lifestyle that you want to live. Whatever can’t be accommodated from your pension, Social Security and other income sources is going to have to come from your investments. Although this can vary based on a wide variety of multiples, most people can reasonably maintain a sustainable annual withdrawal rate of 3%-5% from their portfolios over time; adjusted with inflation. Is this enough? If not, then you will need to go back to the drawing board to re-think your long-term plans. This may involve scaling back your expected lifestyle, working longer or taking more risk in your portfolio. But in the end, the plan should take dictate the investment strategy, not the other way around.

Once you determine your needs, then you have to focus on what is critical in a retiree portfolio. These are the two factors that are most important:

1.) Growth Isn’t Optional Anymore: The greatest financial risk to the retiree of today is longevity. This is coupled with the fact that the major expenses of retirement, travel and entertainment in the early years to health and/or long term care costs in later years are growing at a faster rate than inflation. Most retiree’s can’t afford the luxury to have a portfolio that’s main objective is income and principal preservation. Growth isn’t an option for the retiree of today; it’s a necessity.

2.) Volatility is a Killer: Retiring at the wrong time at the cusp of a bear market and being forced to withdraw investments in your initial retirement years at lows can be a disaster; increasing your likelihood of running out of money during your lifetime.

These two factors are the polar opposite of one another. How do you balance off the need for growth while reducing the volatility at the same time? I’ll discuss this in my next entry.